Excerpt from ASC 815-10-15-100
In this form of net settlement, neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). (For example, most interest rate swaps do not require that either party deliver interest-bearing assets with a principal amount equal to the notional amount of the contract.) Net settlement may be made in cash or by delivery of any other asset (such as the right to receive future payments…), whether or not that asset is readily convertible to cash.
Contractual net settlement will most often be made in cash, but there are other forms of settlement. Some of the other forms are discussed in the following sections.
Net share settlement
Net share settlement is a form of net settlement in which the party in the loss position delivers shares with a fair value equal to the loss to the party in the gain position. This is commonly referred to as “cashless exercise,” and it meets the net share settlement criterion in ASC 815-10-15-102
. If either counterparty could net share settle the contract, then it would meet the net settlement criterion —regardless of whether the net shares are readily convertible to cash, as described in ASC 815-10-15-119
The issuer of a contract that meets the definition of a derivative because of a net share settlement provision may qualify for the scope exception for certain contracts involving an entity’s own equity in ASC 815-10-15-74
(a). See DH 3.3
for information on this scope exception.
Net settlement in the event of nonperformance or default
discusses how contracts that contain penalties for nonperformance or default meet the net settlement criterion if the contract’s default provisions call for net settlement upon such nonperformance or default. As a result, reporting entities need to evaluate all default provisions and termination penalties when determining whether a contract includes net settlement provisions.
Figure DH 2-1 summarizes key considerations in evaluating default provisions. See UP 3 for additional information.
Figure DH 2-1 Evaluating whether default provisions constitute net settlement
Net settlement provisions
Not net settlement provisions
- Symmetrical default provisions that allow either party to the contract to unilaterally settle the contract in cash without penalty
- A variable penalty for nonperformance based on changes in the price of the underlying (may be a form of net settlement)
- Asymmetrical default provisions that allow the nondefaulting party to demand payment from the defaulting party in the event of nonperformance, but do not result in the defaulting party receiving payments for the effects of favorable price changes
- A fixed penalty for nonperformance (as the penalty does not change with changes in the underlying)
- A variable penalty for nonperformance based on changes in the price of the underlying if it also includes an incremental penalty of a fixed amount (or fixed amount per unit) that is expected to be significant enough at all dates during the remaining term to make the possibility of nonperformance remote
Symmetrical default provisions
A symmetrical default provision requires an entity to pay a penalty for nonperformance that equals the change in the price of the items that are the subject of the contract. It might be considered a net settlement provision, depending on the specifics of the contract. For example, a liquidating-damages clause that stipulates that if the seller fails to deliver a specified quantity of a particular commodity or buyer fails to accept the delivery of that commodity, the party in an unfavorable position must pay the other party an amount equal to the difference between the spot price on the scheduled delivery date and the contract price, regardless of which party defaulted.
Asymmetrical default provisions
An asymmetrical default provision requires the defaulting party to compensate the nondefaulting party for any incurred loss, but does not allow the defaulting party to benefit from favorable price changes.
An asymmetrical default provision does not constitute net settlement. However, the presence of asymmetrical default provisions applied in contracts between the same counterparties indicates the existence of an agreement between those parties that the party in a loss position may elect the default provision, thus incorporating a net settlement provision within the contract.
In addition, a pattern of settlements outside of physical delivery would call into question whether the provision serves as a net settlement mechanism under the contract. It would also call into question whether the full contracted quantity will be delivered under this and similar contracts.
Net settlement of a contract designated as normal purchases and normal sales would result in a tainting event that would need to be evaluated to determine the impact on the contract itself and other contracts similarly designated as normal. See DH 3.2.4 for information on the normal purchases and normal sales exception.
Penalties for nonperformance
A fixed penalty for nonperformance is not considered a net settlement provision because the amount does not vary with changes in the underlying.
As discussed in ASC 815-10-15-103
(c), a variable penalty for nonperformance is not a form of net settlement if that penalty also contains an incremental fixed penalty in an amount that would be expected to act as a disincentive for nonperformance throughout the term of the contract.
In a structured payout, the payout of the net gain or loss is not made immediately. Instead, the holder may receive a financial instrument (e.g., a receivable) whose terms pay out the gain or loss over time.
As discussed in ASC 815-10-15-104
, a contract that provides for a structured payout of its gain or loss meets the characteristic of net settlement if the fair value of the cash flows to be received or paid are approximately equal to the amount that would have been received or paid if the contract had provided for an immediate payout.
However, as discussed in ASC 815-10-15-105
, a contract cannot be net settled if the holder is required to invest funds in, or borrow funds from, the other party to obtain the benefits of a gain on the contract over time as a traditional adjustment of either the yield on the amount invested or the interest element on the amount borrowed. A fixed-rate mortgage commitment is an example of this type of contract. To benefit from the gain on a loan commitment (due to an increase in interest rates), the holder of the loan commitment must borrow money from the lender.
In contrast, when a contract requires an investment of funds in, or borrowing of funds from, the other party so that the party in a gain position under the contract obtains the value of that gain only over time through a nontraditional or atypical yield, net settlement does exist because the settlement is in substance a structured payout of the contract’s gain. ASC 815-10-55-21
illustrates this concept.
Excerpt from ASC 815-10-55-21
For example, if a contract required the party in a gain position … to invest $100 in the other party’s debt instrument that paid an abnormally high interest rate of 5,000 percent per day for a term whose length is dependent on the changes in the contract’s underlying, an analysis of those terms would lead to the conclusion that the contract’s settlement terms were in substance a structured payout of the contract’s gain and thus that contract would be considered to have met the characteristic of net settlement ...
Net settlement of debt through exercise of an embedded put or call option
Settlement of a debtor’s obligation to a creditor through exercise of a put or call option embedded within the debt meets the net settlement criterion because neither party is required to deliver an asset that is associated with the underlying. See DH 4.4.3 for additional information.